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Monday, October 12, 2015

Insurance Is Bad


Note: This and one or more follow-up posts contain nothing that the smart and well-informed regular readerAfter all, these readers had the wisdom and good taste to visit here. will not already know. But a surprising number of people without florid mental deficiencies and with a number of certificates indicating that they at least spent a substantial number of years in educational institutions seem to unaware of these facts or at least have them readily slip their mind in certain settings. Rather than explaining these facts over and over again, these posts will do so once and for all; in the future, one can then just refer such to these pages. The regular reader is invited to just skip these posts or just read them for the snark and jokes, as per usual practice mostly in the footnotes. Mostly.Incidentally, mostly also appears to be the author’s six-year old daughter’s new favorite word. Last night she asked her father for help closing some buttons on her, or rather the author’s borrowed, shirt. You see I am not really an expert on buttoning. So you think I am an expert on buttoning? Yeah. Mostly.

Insurance is a bad deal; the expected dollar value of getting insurance is always negative. In other words, on average everybody will always be better off not getting insurance.

This is not because insurance companies are run by Evil White Men who probably are Any Rand fans and beat their wifes. It would be true if all insurance companies were non-profits staffed, from the claims adjuster to the CEO, exclusively by angels who refused any salary beyond the minimum wage and performed their often-demanding jobs with perfect skill. Nor is it because, speaking candidly, of some neoliberal sophistry. It is not even because of economics. It is because of simple accounting:

Insurance companies do not have magic money-printing presses in their basements.If they did, why go through all the hassle of running an insurance company, rather than just the presses? Hence, their inflow of cash—the premiums—must on average over the long run at least match the outflow of cash—payouts to policy holders and operating costs, like employee salaries. As the operating costs are larger than 0, it follows that, on average, the amount the insurance company receives in premiums from each policy holder must exceed the amount it pays out to this policy holder.

Moreover, as long as insurance rates and policies are unregulated and there is a competitive market for insurance, this most hold not only for the average policy holder, but also for every single policy holder. If one insurance company decided to charge some policyholders a premium below the expected payout and made up for it by charging some less favored policyholders much more than the expected payout, those disfavored policyholders would just switch to another insurance company which does not play favorites. The favorites-playing insurance company would soon find that no longer has any disfavored policyholders and would be forced to raise the premiums to the favored policyholders to again exceed the payouts to the favored, or go bankrupt.This is related to the reason that legal schemes, like ObamaCare, to force all insurance companies to play favorites (like the exclusion of preexisting conditions), which the public loves, are always accompanied by mandates on policyholders (like the individual and the employer mandates), which the public hates. The public does not realize, or does not want to realize, that these are two sides of the same coin.

Having established that insurance companies must, by accounting necessity and a little bit of economics, take more in premiums from every policyholder than they can expect to pay out, the flip side is also proven: If you are a policyholder you must always expect to pay more in premiums than you can expect to receive in payouts; that is the original proposition stated at the beginning. For everybody, insurance costs on average more than it pays.

So why do apparently intelligent people buy insurance without any legal requirement to do so? Shrewd traders have bought insurance for their ships and cargo against mishap at sea on the markets of Lloyd’s of London for 327 years. Responsible and intelligent home owners buy insurance which pays out when their house burns down. Does this not disprove the argument above?

Not quite. While insurance policies must always have a negative expected value in dollar terms, they do not necessarily in terms of utility. In particular, most people are somewhat averse to taking the risk of unlikely, but disastrous, outcomes. People will rationally pay $1,000 every year to insure against a 1-in-a-1000 annual risk of losing $800,000. Insurers will happily write a thousand such policies and expect to clear $200,000 every year from them. This is the only reason that taking out insurance can sometimes be a wise choice and the existence insurance companies sometimes contributes to the general welfare.

But equally important as the existence of this exception are its limitations. Insurance only makes sense when:

  1. The loss, if the risk occurs, is very large.
  2. The risk is either entirely out of the policyholders control or the policyholder, even with insurance, retains adequate incentives to avert the risk.That is of course the old, but true story of Moral Hazard.
  3. The risk is not predictable and, in particular, has not yet occurred.

When any of these conditions fail, insurance become lunacy.

To illustrate these points, imagine that Sen. Warren discovered the ever-rising priceWell, not really, but most people think so and that is good enough for political work. of gasoline and the enormous plight it inflicted, particularly on vulnerable groups like the Poor or Rural Americans. To put an end to this scourge, Sen. Warren proposes the Open Roads for All Act (ORFAA) requiring that car insurance must cover gasoline, while singing odes to the Joys of Mobility. On a wave of populist support, ORFAA is enacted. What would happen?

The first thing is that shopping for gasoline would suddenly get a whole lot less convenient. Rather than just pulling into any gas station, filling the tank, paying and driving off, the motorist would first have to research which gas stations are in-network for their car insurance. Then the motorist would made an appointment with the gas station’s insurance handlers, verify the motorist’s and the gas station’s gas coverage and its limitations. Only then would the motorist receive the allocated gasoline. Afterwards, of course, the motorist (or the gas station) would submit an claim to the insurer and usually after a few weeks a check would arrive covering the cost of the gas (minus a co-pay, of course). Sometimes it would not work as smoothly, and there would be coverage disputes and the motorist, the insurer, and the gas station will spend many entertaining hours settling who will ultimately pay for the gas.

The second thing is that car insurance premiums would rise for the insurers need some source of revenue to pay for the gas (not to mention the labor of a vast army of gas insurance claims adjusters). Indeed, for the reasons stated above, motorists would find that their insurance premiums had gone up by an amount substantially larger than what they used to pay for gas out of pocket. That is unsurprising: the underlying price of gasoline has not suddenly dropped or disappeared just because the money that pays for it is cycled through the insurer, rather than going directly from the motorist’s to the gas station’s pocket. And somebody also has to pay the salaries of that newly required army of insurance adjusters.Sen. Warren would of course indignantly reject any right-wing smear campaign—probably funded by the oil and insurance industries—trying to link her and ORFAA to these developments; no, the blame belongs to the gaping greed of the insurers, which just coincidentally happened to increase just as ORFAA was passed.

But the fun does not end there. For the insurers would find that—strangely—everybody would be driving more and using more gas, now that insurance finally covers. So both the total quantity of gas consumed and predictably the unit price of gas rise. Moreover, insurers would discover that even so, some policyholders use a lot of gasoline, while others use little or none. To address this imbalance, insurers would offer different policies (e.g., Light Driver, Long-Distance Racer, Electric Car Owner) each coming with a different monthly quota of gasoline. In the end, all motorists would find that they end up paying exactly the same for gasoline as they did before (plus a 50% or so insurance overhead), but in an enormously less convenient manner.Unless, of course, the wise Warren had included a provision in ORFAA outlawing such nefarious discrimination. Then we’d just be stuck with everybody driving more, filling out a lot more forms, and gas prices increasing across the board.

Or consider a Sen. Sanders moved by the plight of certain homeowners who lacked fire insurance and were ruined when their houses burned down. Sen. Sanders summons a collection of such unfortunates to a Congressional hearing where they—Middle American Salt-of-the-Earth types, every one—movingly testify as to their plight even as they fight back tears. They testify that, even as they stood outside their burning homes, they had frantically dialed up insurer after insurer, trying to rectify their earlier oversight. But the insurers, when learning that the house was already on fire, had cruelly refused to issue them new policies on the spot; some even went so far as to mock these victims by apparent willingness to issue a policy immediately, but then quoted a premium that was equal to the value of the house! So the beneficent Sen. Sanders introduces the Justice For Burn Victims Act (JFBVA) which requires every insurance company to issue fire insurance on the spot (the must-issue requirement) and without regard to the current thermal state of the house (the preexisting condition ban). JFBVA too passes.

But again the results are perhaps not quite what Sanders and the JFBVA supporters imagined. For now that any homeowner has the option to buy fire insurance only when the fire has started, why would any sane person buy fire insurance earlier and pay premiums for decades and likely receive nothing? At that point, the only ones buying fire insurance would be owners of burning buildings and the insurers—no money-printing presses in the basement, remember—would be forced to increase the premium to the value of the building (plus a bit for insurance overhead). Of course at that price, not even people with houses on fire would want to buy fire insurance. JFBVA with the proclaimed aim of widening the ownership of fire insurance would instead effectively have outlawed it entirely.

TL;DR: Insurance is bad. It will always cost you more than it pays. Only ever consider it for risks that are (1) large, (2) uncontrollable, and (3) uncertain.There are a few additional situations in which generous insurance can make sense; tax treatment, sometimes makes over-insurance individually (but not socially) optimal; liquidity limitations can make even mandatory insurance optimal. More of these anon, if there is interest.